4

Elasticity

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Price Elasticity of Demand

Formula

Measures buyers responsiveness to

price changes
Formula for price elasticity of demand

Ed =

Percentage Change in Quantity

Demanded of Product X
Percentage Change in Price
of Product X

LO1

Price Elasticity of Demand

Formula

Use the midpoint formula

Ensures consistent results
Ed

Change in quantity
=
Sum of quantities/2

Change in price
Sum of prices/2

Q2 Q1/ (Q1 + Q2) / 2

=

P2 P1 / (P1 + P2) /2
LO1

Price Elasticity of Demand

Formula

Use percentages
Not dollar price change
Compare responsiveness across

LO1

products
Eliminate the minus sign
Easier to compare elasticities

Interpretation of Elasticity of
Demand

Ed > 1 demand is elastic

Ed = 1 demand is unit elastic
Ed < 1 demand is inelastic
Extreme cases (next slides)
Perfectly inelastic

Perfectly elastic
LO1

Extreme Cases
P

D1
Perfectly
inelastic
demand
(Ed = 0)

Perfectly inelastic demand

LO1

Extreme Cases
P

P0

D2
Perfectly
elastic
demand
(Ed = )

Perfectly elastic demand

LO1

Total Revenue Test

Total Revenue = Price X Quantity

If Inelastic demand (next slide)
P and TR move in the same direction

If Elastic demand (next slide)

P and TR move in opposite directions

LO2

Inelastic DD & Total Revenue Test

A lower price, inelastic demand, TR drop

Orange loss exceeds blue gain
P

$4

c
3

D2
0

LO2

10

20

Elastic DD & Total Revenue Test

A lower price, elastic demand, TR rise

Blue gain exceeds orange loss
P
$3

D1

LO2

10

20

30

40

Total Revenue Test

Lower price and unit elastic demand

Blue gain equals orange loss
P
$3

D3
0

LO2

10

20

30

DD Curve, Ed, Total Revenue Test

Price Elasticity of Demand for Movie Tickets as Measured by the Elasticity
Coefficient and the Total-Revenue Test
(1)
Total Quantity of
Tickets Demanded per
Week, Thousands

(2)
Price per Ticket

$8

(4)
Total
Revenue
(1) X (2)

(5)
Total
Revenue
Test

$8,000

5.00

14,000

Elastic

2.60

18,000

Elastic

1.57

20,000

Elastic

1.00

20,000

Unit Elastic

0.64

18,000

Inelastic

0.38

14,000

Inelastic

0.20

8,000

Inelastic

7
8

LO2

(3)
Elasticity
Coefficient
(Ed)

High
price

low
price

Price

DD curve, Elasticity and Total

Revenue
$8
7 a
b
6
c
5
4
d
e
3
2
f
g
1

Elastic
Ed > 1
Unit Elastic
Ed = 1
Inelastic
Ed < 1
h

0 1 2 3 4 5 6 7 8

Total Revenue
(Thousands of Dollars)

Quantity Demanded

$20
18
16
14
12
10
8
6
4
2

TR
0 1 2 3 4 5 6 7 8
Quantity Demanded

LO2

Summary for Ed
Ed > 1, %P , %Qd , TR
Ed = 1, %P , % Qd

, TR

Ed < 1, %P , % Qd

, TR

Determinants of Elasticity of
Demand

Substitutability

More substitutes, demand is more elastic

Proportion of Income
Higher proportion of income, demand is more
elastic

Luxuries vs. Necessities

LO1

Luxury goods, demand is more elastic

Time
More time available, demand is more elastic

Price Elasticity of Demand

Selected Price Elasticities of Demand
Product or Service

Price Elasticity
of Demand (Ed) Product or Service

Price Elasticity
of Demand (Ed)

Newspapers

.10

Milk

.63

Electricity (household)

.13

Household appliances

.63

Bread

.15

Liquor

.70

MLB Tickets

.23

Movies

.87

Telephone Service

.26

Beer

.90

Cigarettes

.25

Shoes

.91

Sugar

.30

Motor vehicles

1.14

Medical Care

.31

Beef

1.27

Eggs

.32

China, glassware

1.54

Legal Services

.37

Residential land

1.60

Automobile repair

.40

Restaurant meals

2.27

Clothing

.49

Lamb and mutton

2.65

Gasoline

.60

Fresh peas

2.83

LO1

Applications of Ed

Large Crop Yields (e.g. potatoes)

SS rise, P drop, assume Inelastic
demand, Qd increases little, total
revenue decreases

Excise Taxes (e.g. beer)

P rises, Inelastic demand, Qd

decreases little, total revenue rises

LO1

Lecture 5
Objective:
1. Price elasticity of supply and its
determinants.
2. Cross- and income elasticities of demand.
3. The law of diminishing marginal
utility
4. Theory of consumer choice

Price Elasticity of Supply

Measures sellers responsiveness to

price changes
Formula to compute elasticity
Es > 1 supply is elastic

Es < 1 supply is inelastic

Es =

LO3

Percentage Change in Quantity

Supplied of Product X
Percentage Change in Price
of Product X

Price elasticity of supply

Elastic supply, producers are

responsive to price changes

Inelastic supply, producers are not
responsive to price changes

Price Elasticity of Supply

*Time is primary determinant of

LO3

elasticity of supply
Time periods considered
Market period (immediate period)
(see slide 21)
Short Run (fixed and variable i/ps)
(slide 22)
Long Run (slide 23)

Elasticity of Supply: The Market

Period (Immediate Period)

Perfectly inelastic supply

P
Sm
Pm

P0

D2
D1
Q0

LO3

Elasticity of Supply: The Short

Run
Supply is more elastic than in market
period
P

Ss

Ps

P0

D2
D1
Q0 Qs

LO3

Elasticity of Supply: The Long Run

Supply is even more elastic than in

the short run
P
Sl

Pl
P0

D2
D1
Q0

LO3

Ql

Applications of Elasticity of
Supply

Antiques
Inelastic supply
Reproductions
More elastic supply
Volatile gold prices
Highly Inelastic supply

LO3

Cross Elasticity of Demand

Measures responsiveness of sales to

change in the price of another good

Substitutes positive sign
Complements negative sign
Independent goods - zero
Percentage change in quantity demanded of product X

Ex,y =
Percentage change in price of product Y
LO4

Cross Elasticity of Demand

Application
Company Change the price? (Yes,

LO4

if low +ve value implies weak sub.)

Allow a merger? (No, if high +ve
value)

Income Elasticity of Demand

Measures responsiveness of buyers

to changes in income
Normal goods positive sign
Inferior goods negative sign
Percentage change
in quantity demanded
Ei =
Percentage change in income

LO4

Income Elasticity Insights

High income elasticities

Most affected by a recession
Low or negative income elasticities
Least affected by a recession
Note: -ve income elasticities
associated with inferior goods

LO4

Ex,y and Ei
Cross and Income Elasticities of Demand
Value of
Coefficient
Cross elasticity:
Positive (Ewz > 0)
Negative (Exy < 0)

Description
Quantity demanded of W changes in same
direction as change in price of Z

Type of Good(s)
Substitutes

Quantity demanded of X changes in

Complements
opposite direction from change in price of Y

Income elasticity:
Positive (Ei >0)

Quantity demanded of the product changes

in same direction as change in income

Normal or superior

Negative (Ei<0)

Quantity demanded of the product changes

in opposite direction from change in income

Inferior

LO4

Elasticity and Pricing Power

Charge different prices based on

price elasticities
Examples:
Business and leisure air travelers
Adult vs. child